What’s the UK government’s plan?

UK Chancellor Rachel Reeves has confirmed the government will introduce legislation next year to regulate agencies that evaluate company environmental, social and governance (ESG) credentials.(1) The Financial Conduct Authority (FCA) will set up and administer the regime.

What’s the global background?

The following markets have already taken steps towards regulating agencies that rate companies on an ESG basis: 

Most of the above markets have based their rules or guidelines on the International Organization of Securities Commissions (IOSCO) recommendations from 2021.(2)

IOSCO raised concerns that growing use of ESG ratings and data in investment decision-making, in the absence of regulatory oversight, poses risks to ‘investor protection, the transparency and efficiency of markets, risk pricing, and capital allocation’.(3)

IOSCO’s recommendations for ESG ratings agencies include:

India

India’s regulation strays from the IOSCO recommendations by requiring ratings providers to focus explicitly on aspects that are ‘contextual to the India market’, with a list of India-specific parameters.(4)

European Union

The EU was next with a provisional political agreement still subject to approval. It largely follows IOSCO’s recommendations, but includes more detailed transparency requirements, which could also apply to some proprietary ESG ratings by asset managers.

Asia

In Asia, voluntary codes of conduct have been introduced for ESG ratings providers in Singapore, Hong Kong, Japan, Korea and Taiwan. In Singapore, for example, those in scope are invited to endorse the Code of Conduct, on a "comply" or "explain" basis. This comes with disclosure requirements and notification to the regulator (MAS).(5)

Regulation is expected to follow in these regions, though timelines are not yet established.

What’s our take on ESG ratings regulation?

We welcome transparency on ESG ratings. Growing demand and regulatory scrutiny has increased the industry’s reliance on ESG ratings and data to substantiate sustainability claims within funds. This is particularly true for smaller players with more limited resources.

Robust methodology required

It’s increasingly important that ESG ratings follow a robust methodology and that we have a clear understanding of what they are (and are not) telling us.

The growing use of ESG ratings in fund criteria means that poor ESG ratings and downgrades have the potential to restrict investment or force sustainability-focused funds to divest. This could have an impact on market pricing.

A clearer approach to controversy assessments?

Controversy assessments are common causes of unanticipated downgrades, especially those deemed to constitute a breach of international norms such as the UN Global Compact (UNGC), a common exclusion for sustainability-focused funds. 

But there is currently no authoritative source for UNGC breaches. It’s a subjective assessment where ESG ratings agencies can and do come to different conclusions. Agencies need a transparent approach based on accurate information.

Where mandated to do so in our sustainability-focused funds, we can use our internal insights to override a rating agency’s UNGC fail status following an internal review and oversight process. In multiple instances, where we have overridden this, we found that our ESG rating provider changed their view shortly afterwards.

Communication is crucial

Our investment teams have also at times heard from frustrated investee companies who have learnt that their ESG assessments are based on incorrect information.

But they have struggled to get rating agencies to engage and correct this. Requirements for rating agencies to communicate more with those they are rating should help to mitigate this. That said, companies may continue to disagree with the conclusions.

What’s next?

The UK is expected to table its regulation in 2025, so we’ll know more at that point. In the meantime, the government is encouraging ratings agencies to voluntarily adopt the code of conduct developed by the International Capital Markets Association and International Regulatory Strategy Group. This code may offer a template for the regulation.

The EU regulation still needs to be agreed by the European Council and European Parliament, which will potentially be at the end of this year or into 2025, with the requirements coming into force 18 months later.

While we have been surprised before, the current draft is expected to be the near-final version.

In Asia, we’ll be looking out for tangible plans for regulators to turn voluntary codes into hard law in the future.

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